Wednesday, January 30, 2008

Easy? You call that easy?

Markets like this one are the enemy of solid fundamental analysis. It can cause otherwise good traders to start just guessing, resulting in either panic selling or simplistic buying (you know the old, “if you like it at $30, you love it at $15!” trade.)

One area where the value proposition is relatively simple is high-yield bonds. Bonds offer a very straight forward fundamental risk-reward situation: the reward is the yield, the risk is defaults. As of 1/25, Lehman’s High Yield Index yields 10.08%, or 672bps over Treasuries. That’s your reward in hard numbers. So what about defaults?

The following chart shows annual credit losses (that’s defaults less recovery) for high-yield bonds since 1982. The data is from Moody’s 2007 Default Study, and includes all Moody’s rated high-yield bonds.

I've labeled the recessionary periods of 1990-1991 and 2001. So in 1990, if you had owned the entire universe of Moody’s rated high-yield bonds, you would have suffered credit losses of 6.3%. The greatest credit loss rate of the last 25 years was in 2001 at 8.3%. So if the 2001 experience were to repeat itself in 2008, investors would earn 10.08% in interest versus 8.3% in credit losses. Determining the exact total return would depend on the timing of the defaults, but the number would almost certainly be positive.

So could defaults be worse in 2008 vs. 2001? Remember that the 2001 recession was all about over-investment in technology and telecommunications. There were also some very large defaults that were due to unique circumstances, namely Enron, Worldcom, and various airlines. If there is a recession in 2008, it will be about over-investment in housing. Very few high-yield issuers are involved in the housing market. Virtually all banks, brokerage firms, mortgage insurers, etc. are investment grade.

Of course, its possible high-yield spreads move even wider. According to Lehman Brothers, the high-yield index spread got as wide as 1036bps in 2002 vs. only 672bps today. Perhaps spreads will widen further, but don’t get caught fighting yesterday’s war. In 2001-2002, the corporate bond market suffered from a series of accounting scandals, which resulted in investors questioning the veracity of financial statements in general. That fear hit the high-yield market directly. Today the fear is related to mortgage lending, a business dominated by investment-grade companies.

For that matter, the 1990-1991 period was also unique, in that it saw the demise of Drexel Burnham Lambert. Drexel and its star banker Michael Milken created the modern high-yield market, and for several years was the primary market maker. Drexel’s fall from grace put the future of high-yield in serious doubt.

If we do have a recession in 2008, high-yield default rates will certainly increase. But at today’s valuation levels, high-yield already has a recession priced in. Given that there is good reason to believe credit losses will be no worse, or perhaps even better than the last two recessions, high-yield looks fundamentally attractive.

Wednesday, January 23, 2008

Picked a bad week to go on vacation...

I should have checked my calendar more closely. I didn't realize this was "Market goes insane week."

Here are a few quick thoughts on the market's activities of the last couple days.

  • The stock market is trying to price in a recession. The credit market had already priced this in, and now it seems as though the credit market stands more to gain from here than stocks. Consider that credit benefits more directly from Fed cuts, which will help many firms sell new debt and survive. Stocks need profit growth.
  • Why did the Fed cut 75bps on Tuesday, but only 25bps at the last regular meeting? I know every one is asking the same question, but let me send out a big WTF to Ben Bernanke and Co. on this move. It seems clear to me the reason was in reaction to the severe sell-off in Europe and Asia on Monday. So now the Fed is directly targeting the stock market? I mean, that's how it comes off. The perception would have been different had they cut 50bps at the last regular meeting, and then did a inter-meeting 50bps on Tuesday.
  • Bail-out for ABK and MBI? Sounds more and more likely something is going to happen. The story from the WSJ makes it sound similar to the LTCM bailout, where a group of parties interested in seeing the bond insurers survive provide the capital, not as a strategic investment, but to protect themselves from bigger losses. I've said before that I don't like a government bailout, but if a group of banks/brokers have essentially bet too heavily on bond insurers surviving, then they should pay the price when the insurers need more capital. Nothing wrong with that.

More on the markets when I get back in front of a Bloomberg on Monday.

Tuesday, January 15, 2008

He could destroy us

You will seldom hear a more vocal defender of capitalism than myself. I tend to be for allowing the market to find its own way, and keeping the government as far away from commerce as possible.

Capitalism works on a few simple principles, which I'm sure I hardly need to recount to AI readers. But the most critical and most fundamental principle is that of incentives. Capitalism assumes that human beings react to incentives. If a system is devised which incentivizes people to work toward socially beneficial goals, then people will naturally perform socially beneficial activities. Hence why people strive to invent new products, devise new production processes, discover new medicines, etc. The dream of striking it rich compels people to pursue all sorts of positive achievements, and mankind has certainly benefited from these pursuits.

In some corners, however, the modern incarnation of Smith's capitalism has become divorced from its core principles. Take Countrywide CEO Angelo Mozilo. He founded the company in 1969 and grew it into one of the largest mortgage underwriters in the U.S. For his success, Mozilo has certainly been well-rewarded over the years.

Today, of course, Countrywide is in serious danger of bankruptcy. The mortgage business is going through a historically difficult period, and if it weren't for a recently announced merger with Bank of America, Countrywide's future as a going concern would be very much in doubt. We could debate the degree to which Mozilo is personally responsible for Countrywide's sudden collapse. But what cannot be denied is that under Mozilo's leadership, Countrywide has destroyed shareholder value over the last 10 years.

And yet Mozilo looks to walk away with a gigantic pay day. According to Bloomberg News, Mozilo could walk away with as much as $84 million assuming the merger goes through. There are some circumstances in which the number could be lower, or even zero. Regardless, the mere possibility that Mozilo would enjoy such a payout creates a perverse incentive.

In any free market system, there will be failures. The dream of riches has to have a downside. With the potential for great success must also come the potential for great failure. Without a penalty for failure, economic agents would be incentivized to take inordinate risks. In private companies, this risk is naturally managed. Small business owners normally must put up their own capital, or borrow against existing assets, such as their homes. Obviously an entrepreneur believes in his new business idea if s/he is willing to mortgage his home and life savings to fund it. Whether the business winds up succeeding or not, the incentives are for the entrepreneur to create value.

Mozilo may have been an entrepreneur once upon a time, but today he's the CEO of a very large public corporation. He knew his company had a large servicing portfolio which would have value to a larger financial institution, regardless of how the rest of his business was performing. He had a long standing relationship with Bank of America, and indeed was supposedly discussing a merger late in 2006. Mozilo could rationally conclude that he'd be able to sell Countrywide, whether to Bank of America or some other institution, in the event Countrywide ran into serious trouble.

With this in mind, what were Mozilo's incentives in recent years? Countrywide's shares had been languishing in the upper 30's for most of 2005, 2006 and early 2007. No doubt Mozilo's personal stock and stock options were not gaining much during this period. Let's be particularly cynical and suppose that Mozilo saw that sub-prime lending had gotten out of hand, and many bad loans were being made. If he was motivated primarily by personal wealth accumulation, then he was probably wise to just keep making those bad loans. After all, the only way Countrywide's share price was going to rise, and create wealth for Mozilo himself, was for the company to grow EPS. In order to do that, they had to keep making loans. Pulling back and tightening credit standards would only slow revenue.

So if Mozilo wanted to grow his personal wealth by pushing the share price higher in the short-term, he would do well to bet heavily on good times. All the while knowing that if it all went to hell, he would just sell the company and collect his exit pay.

Now, we don't actually know what Angelo Mozilo thought about the housing market in 2005 or 2006. We know what he said publicly, but we'll never know what he really believed in his own mind. Perhaps his motivations were noble, and he was merely wrong about the lending business. Even if that's true, the fact that his incentives were otherwise is a serious problem for modern capitalism.

I don't know what the solution is here. Perhaps it is nothing more than having investors put more pressure on compensation committees to create better incentives. Maybe it means that more businesses should stay private. But the problem of perverse incentives is the biggest single problem facing capitalism today. The sub-prime mess will come and go. This is a bigger problem.

Friday, January 11, 2008

Countrywide: I'm saved!

What should we take away from the Countrywide/Bank of America deal?

First, its obviously good for market liquidity that Countrywide won't wind up in bankruptcy. While I think the economy could have handled a Countrywide liquidation, it would have been painful and messy. I'm sure Ben Bernanke is happy about this turn of events. Notice that Fannie Mae and Freddie Mac stock were both up solidly today.

Second, it tells you that Bank of America, at least, is willing to look past the current period into a time when the mortgage business has improved. We all know such a time will come, and the banks which have strong capacity at that time will enjoy strong profits.

Third, this obviously puts Washington Mutual in play. Today WaMu stock opened up about 7%, and their bonds rallied significantly. J.P. Morgan is rumored as the acquisitor, and there is probably only a couple other banks which would even be possibilities. I heard Wells Fargo's name mentioned, and they'd have the capital, but it would be a strange marriage for such a conservative bank. You could also imagine some Mid-West or East Coast bank having interest in WaMu's geographical footprint, but I'm not sure any such banks have the spare capital to absorb WaMu's problem assets. US Bank? Fifth Third? PNC? I doubt it. If I'm Jamie Dimon, even if I'd really like to own WaMu, I wouldn't let BofA's move force my hand. JPM may be the only actual bidder, and WaMu is probably only going to get more desperate.

We should all remember that the credit market will likely improve before the economic picture does. In other words, the credit market is forward looking, and currently spreads indicate that the forward picture is bleak. All it will take for improvement in credit spreads is for conditions to indicate that the future will be somewhat less bleak. I'm seeing too many commentators merely conclude that credit (or stocks) are a bad play simply because the economic picture is poor, which is inadequate analysis. In order to be bearish on a security, you have to assume that conditions will be worse than what's priced in. By the time conditions actually improve, the market will have long since risen.

Wednesday, January 09, 2008

I felt it too

First let me say that I'm not surprised the market rallied strong today. Like I said yesterday, we knew Countrywide was in serious trouble. We've known this for months. Why does the market sell off 200 points on news that was widely expected? With the market taking about 2/3 of it back today, I'd say that sell-off was mostly fast money driven.

That doesn't mean we won't keep going lower. As I discussed the other day, it sure seems like the corporate bond market is set up for a much worse economic outcome than the stock market. Corporate bond spreads are as wide or wider than the last 2 recessions, and yet the stock market valuations seem sanguine on the topic.

But there are some good arguments for the diversion. First of all, the corporate bond universe and the stock market universe are not the same data set. Here are the top 10 investment-grade bond issuers:

General Electric
Goldman Sachs
Bank of America
Morgan Stanley
JP Morgan
Merrill Lynch

Here is the top 10 for the S&P 500
Exxon Mobil
General Electric
Procter & Gamble
Johnson & Johnson
Bank of America

Within the S&P 500, only GE, AT&T, and Bank of America would appear on both lists. And interestingly, among the top 10 corporate list, only AT&T's stock is closer to its 52 week high than its 52 week low.

So perhaps the divergence in corporate/stock valuations isn't so strange after all. Perhaps the kinds of companies who are large bond issuers are struggling in the stock market as well. Perhaps the kinds of companies which are keeping the stock averages afloat are not big bond issuers: XOM, MSFT, PG, etc.

We may be looking at a sort of weird recession coming up. One where layoffs aren't as bad as some past recessions, but consumer spending drops substantially anyway, because of credit availability. I could see such a recession not being terribly bad for stocks. But financials are right on the forefront of these problems. If that's how it plays out, then the financial-laden corporate bond indices will at best stay wide for a while, even if the stock market improves.

Tuesday, January 08, 2008

Countrywide: Surely he must be dead by now.

This morning, rumors were rampant that Countrywide was to declare bankruptcy sometime this week. The company denied the rumors, saying in an e-mail to major media outlets: "I feel happeeeeeee!"

Here is what I find particularly interesting about today's market.

First, I'm not sure why a potential Countrywide bankruptcy should send the market reeling like this. You know when you and your friends start talking about old movies or old bands? Inevitably someone names some actor or musician and someone says, "I just saw him on TV the other day." And someone else says "He's still alive?" I kind of feel that way about Countrywide.

Second, didn't Countrywide claim they were going to post a profit in 4Q? It sounded doubtful to me when they said it, and its not like things have gotten better in the mortgage market since. Maybe they do manage to pull it off, and if so, that stock will surge. But I sure as hell ain't buying.

Third, here are the bid/ask levels I'm hearing for Countrywide bonds... (by maturity, in dollar price)

2/08 -- 90/92 (floater)
5/08 -- 82/84
4/09 -- 63/65
6/10 -- 61/63
3/11 -- 60.5/62.5
6/12 -- 60.5/62.5

Sounds like the market thinks the recovery is around 60c on the dollar eh?

Friday, January 04, 2008

A disturbance in the Force

I don't comment about the stock market very often, but something isn't right. Take a look at the chart below. The S&P 500 is in red, charted on the left axis. Corporate bond spreads are blue and are inverted on the right hand axis. Thus when the blue line "falls" that should mean the economic picture is deteriorating.

From my seat, watching corporate bond spreads widen dramatically over the last 6 months, you'd certainly think recession is on the horizon. In fact, if you draw a horizontal line from where we are now in corporate spreads, you'd see that we've rarely been wider than current levels. We are wider than the worst points during the 1991 recession and 2001 recession, although we did touch a bit wider during 2002.

And yet the stock market is very near all-time highs. I did this graph up through 12/31, so the S&P would be a bit lower. But the basic story would be exactly the same: the stock and bond markets don't agree about where we're going next.

There are some logical reasons why stocks and bonds can diverge. One is that companies are increasing leverage. So equity returns might increase but bond risk rises. That's not happening right now. Financial companies have gone into capital preservation mode, and all companies are finding the bond market quite inhospitable.

I think the economy is going to be weak in 2008, and corporate defaults will surely rise from the ultra low levels of recent years. That being said, corporate bonds look pretty good right now, given that you are getting paid about as much as you ever have for taking credit risk. I don't know what the catalyst for pushing spreads tighter might be (remember the "proving a negative" discussion). It will probably take most of 2008 for spreads to get markedly tighter. And you can bet on spreads being very volatile.

But what's in store for stock holders? I have a hard time making a good argument for stocks to move a lot higher from here. That's not to say I'd advocate anyone selling all their stock portfolio: even if they manage to get out before a sell-off most people don't buy back in time. But looking at the graph above doesn't inspire a lot of confidence.

Anyone care to make a rational argument for why stocks are holding up?

Thursday, January 03, 2008

That name no longer holds any meaning for me

Words have the power to both destroy and heal.
-The Buddha

In thinking about where the economy, Fed, and markets will be going in 2008, I find my thoughts dominated by considerations of liquidity. Readers have heard me use the term "liquidity crisis" or "credit crunch" during 2007, but have rarely (if ever) seen me use "credit crisis" or "solvency crisis." This is purposeful.

Why do I avoid calling this a credit or solvency crisis? Surely I am not here to downplay the problems we're having in residential lending, or even consumer finance in general. I hardly need to enumerate the many problems in consumer lending. I think mortgage foreclosures will break all records in 2008, probably by a long shot. In addition, other types of consumer lending have and will suffer as well. Consumers have been using equity in their homes to help bail them out of other types of debt for many years, but in 2008, this option will be largely unavailable. The result will be weak performance in everything from auto loans to credit cards.

So are there large numbers of insolvent consumers? Sure. Is it going to create a pretty big problem for the economy generally. Yes. Recession? Maybe, just depends on what else goes right or wrong for the economy. Crisis?

I have a hard time with the word crisis here. Maybe I'm hung up on mere semantics. In my mind, a marriage in crisis is one where divorce is an imminent possibility. Not one where the couple just had a big ugly fight. A political crisis is one where the government might collapse. Not where an election is peacefully contested in the courts. To me, that word "crisis" suggests that action must be taken to avert some sort of disaster.

But what's the disaster right now? Consider these simple facts.

1) Most sub-prime ARM loans had a 2 or 3 year fixed-rate period. Therefore the only loans to reset during 2007 were made in 2005. Prime ARM's typically have a 3, 5, or 7 year fixed-rate period.

2) However, the sub-prime delinquencies in 2006 are the real problem. 2005 isn't showing a radically different pattern than past periods.

Notice the much steeper curve displayed in the 2006 vintage, which is like nothing else on the whole board.

3) In 2006, half of all sub-prime purchase mortgages were made with low or no documentation of income.

4) The Case-Shiller home price index is down 6.1% YOY. It registered its first negative reading in January 2007.

5) Conditions that normally precipitate higher delinquencies, namely unemployment, are not currently a problem.

So let's try to reconcile these three facts with how we'd expect a "normal" borrower (prime or sub-prime) under "normal" circumstances to behave. Normal people buy a house because they want to live there. Sure the fact that homes have historically been a positive investment plays a part, but for most people, their house is their home.

There will be some "normal" borrowers looking at negative equity, either now or in the near future. Of course, if that borrower never paid any attention to home prices around him/her, and just kept paying the mortgage bill every month, the negative equity would be of no moment. Remember if a "normal" borrower living in the house decided to walk away, they'd need to find someplace else to live. Given how badly defaulting on your home will mar your credit rating, the "normal" borrower would be loathe to just walk away, even if s/he is significantly underwater, as long as s/he can make the payments.

Plus, there aren't very many "normal" borrowers who would be underwater right now. Using Case-Shiller's data, only borrowers who put less than 6% down and bought their house late in 2006 would have negative equity currently. Perhaps borrowers in the "boom then bust" areas are more likely to be in a negative equity position. But still, we're talking about a relatively small number of "normal" borrowers.

So where are all these delinquencies coming from? And what does that say about what 2008 will hold?

First I think you have people who are delinquent for "normal" reasons. They've lost their job, they've gotten sick, they gambled away their starship, whatever. This caused them to rack up some credit card debt. In the past this borrower was able to tap home equity and get out of trouble. Unfortunately, the borrower isn't able to do this currently, both because lending conditions are very tight and because the borrower might not have adequate equity.

Like I said, this group probably isn't the lions share of the marginal delinquencies, because we aren't seeing macro events which would cause these events to happen on a large scale.

No, I think the bigger problem is investors. If you buy a property solely for investment purposes, then all the rules of a "normal" investor are out the window. I think many investors bought properties with little to no down payment. Investors were more likely to get involved in hot neighborhoods, where prices have probably been hit hardest lately.

Many investors just don't have the option of sitting on the property. If you bought an investment property but also had a house you are living in, you may not be able to afford two mortgages indefinitely. And you probably can't rent the place for the same amount as your mortgage payment. It might be that you can save your actual home by just walking away from your investment property. For the investor, the jingle mail option may just be the best of a bad situation.

So back to the "crisis" question. It is these speculators who are insolvent. So what we have are people who speculated in houses and lost. We have are banks who lent to the a fore mentioned speculators and have lost too. Bear in mind, these banks are the ones who agreed to limited documentation of income (perhaps so the speculator could claim this would be his/her primary residence?) or minimal down payments.

What we also have are brokerage firms who warehoused bonds backed by these speculation loans, assuming they'd be able to unload them into a CDO. They've lost too. We have banks buying AAA-rated CDO^2, who never asked why CDO^2 spreads were so much wider than other AAA product. Guess what? They've lost too. We have money markets buying securities they didn't understand. Losers. We have hedge funds who took already leveraged CDO and ABS product, and leveraged it some more! Loo--oo--oooooooser!

All this isn't a crisis. Its how the credit cycle works. When credit becomes too easy, bad loans get made. People get hurt. But that's the way of the world. You move on.

Where a crisis could develop is when the innocent are hurt just because capital becomes tight. Where a good borrower can't get a mortgage loan. Where a solid commercial real estate project can't roll over its bridge loan because banks are short on capital. That's where the real crisis can get going. Foreclosures happen that didn't need to happen, driving the price of assets lower. Lenders start taking losses on good loans, and suddenly are unwilling to lend to anyone. Investors struggle to value assets, not because of unknown losses, but because of unknown liquidity. Bids disappear.

That's a crisis.

Wednesday, January 02, 2008

How municipal bond insurance works

(Alternative title: 10,000?!?!)

The sub-prime woes of 2007 have thrust bond insurers into the spotlight, and for the first time really calling into question the utility of municipal bond insurance. I have received a number of e-mails and comments from municipal bond investors expressing concern over the quality of their portfolio. I thought it would therefore be useful to discuss how muni insurance works, and what the decline of any municipal insurer would mean for municipal credit quality.

First a couple notes about municipal bonds. The term "municipal" is a bit of a misnomer, since any tax-exempt bond is generally considered a "municipal." That includes not only states, counties, and cities, but also government-related entities (such as a public university) and non-profit organizations (such as a hospital or private university). States, cities, counties and school district bonds which have pledged their full taxing power to bond holders are called general obligation. All other issues are called revenue bonds. Readers should note that governmental authorities are often not funded out of the state's general revenue, but out of their own revenue stream. For example, the Maryland Transportation Authority's revenues come from tolls and the state fuel tax. It would be theoretically possible for the Transportation Authority to be bankrupt without the state defaulting on anything.

"Zero Loss"
Municipal default rates are far lower than their corporate counterparts, as the following chart from Moody's shows.

In fact, there has been only one General Obligation issuer rated by Moody's which defaulted since 1970, and in that case, the default was cured (paid in full) 15 days later.

Certain revenue issues are considered so fundamental to the operation of the government that the odds are low that any government would allow the issuer to fail. These bonds are called essential service bonds and bonds within this category also have a very low default rate. There is no one definition of essential services, but typically issues for public universities, primary/secondary schools, water and sewer utilities, and state highway authorities fall within this category.

The Aaa-rated insurers, MBIA, AMBAC, FSA, FGIC, XLCA, Assured Guaranty, and CIFG, have historically insured mostly general obligation and essential service bonds. MBIA has a self-described "zero loss" underwriting standard, so concentrating their insurance activities within a very low default risk arena seems to fit.

The Aaa insurers have and do insure other issues, like hospitals or industrial development bonds. But the insurers charge much more for these kinds of projects, and often demand some hefty protection in terms of covenants or pledges. In past talks with people working for insurers, my understanding is that they believe every bond they insure has risk equivalent to a Aa-rated corporate bond or better.

"We could almost buy our own ship for that!"
Now you may be wondering if insurers are underwriting to a zero loss, why do municipal buyers bother with insurance? Well, municipal buyers tend to be very high quality focused. In essence, the municipal investor wants to take advantage of the tax-exemption, s/he isn't real interested in credit risk. So having bond insurance allows the muni buyer to do minimal credit research (if any) before buying a bond. This facilitates liquidity in the muni market, because Street traders can put a reasonable bid on any insured bond without having particular knowledge of the underlying credit.

Who buys the insurance?
Municipals are initially sold to the public through underwriters just like stocks or corporate bonds. The underwriter may be selected in advance (called a negotiated deal) or by competitive bid (called a competitive deal. No really!). In a negotiated deal, the underwriter and issuer jointly decide whether to insure the bond or not. They will solicit bids from various insurers and determine whether the cost of insuring the bond lowers the rate on the bond enough to make insurance worth it. In a competitive deal, the underwriter presents a bid to the issuer, which is an all-in cost of the bonds, including issuance costs and interest rate. If the bonds are to be insured, that's just part of the issuance cost.

In a competitive deal, its often the case that the insurer is contacted about insurance only a couple hours before the bids are due. In the case of essential service bonds with an explicit rating or that the insurer has insured before, the turnaround time on an insurance bid can be mere minutes.

Technically the insurance is bought by investors, as the cost of insurance is taken out the proceeds of the bond sale. It is almost always paid as a lump sum to the insurer when the bond sale settles.

How much does the insurance cost?
Insurance may cost less than 10 basis points as a percentage of the bond deal its an essential service deal with a strong underlying rating. Riskier deals obviously cost more. This highlights why most investors wanted the insurance: it is usually so cheap, why not buy the insurance?

Here it might be helpful to think of municipal insurance the same way you think of homeowners insurance. Everyone knows that if you simply look at the odds of making a claim vs. the cost of insurance, buying insurance is a net negative for the home owner. However, most homeowners would be bankrupt in the event that their home was destroyed, as they would not be able to repay their mortgage. The negative ramifications of this relatively low probability event are so high that home owners willingly buy insurance, knowing its a net negative proposition. Municipal insurance is the same way.

What percentage of municipal bonds are insured?
About 45% of investment-grade munis are insured. In practice, there are two major types of bonds that don't get insured. First is lower-rated issuers, which the insurers either won't insure or for which the price is too high. This would be your A or Baa-rated hospitals, nursing homes, development projects, etc. Sometimes these kinds of issues are insured, and sometimes they are not. If they are not, buyer beware. An insurer probably wanted to charge an arm and a leg because they viewed the bond as risky.

Second is higher-rated issuers. Obviously "natural" Aaa-rated issuers don't need insurance. But also many Aa-rated issuers, especially large and well-known issuers, don't benefit much from insurance. For example, the State of Florida is Aa-rated, but rarely buys insurance for their issues because their credit is well-known. Conversely a school district in rural Kansas would probably pay for the insurance, even if they would have a Aa-rating on their own, because buyers are not familiar with the credit.

Do insured bonds trade with the same yield as other Aaa-rated bonds?
No. Natural Aaa-rated issues typically yield about 10bps less than insured issues. Historically, insured issues trade very similarly to strong Aa-rated issues. Hence why larger, well-known Aa issuers usually don't get insurance.

So what happens if an insured bond defaults?
The insurance policies state that the insurer will pay timely principal and interest. Translated, this means that the insurer will make all payments as though nothing happened to the underlying issuer.

So what happens if an insurer defaults?
Nothing changes about the municipal issuer's obligations to pay investors. Remember that the cost of insurance was paid up front. There are no on-going payments, so neither the investor nor the issuer would have any claim against the insurer so long as the issuer remained solvent.

What about the ratings? What is an underlying rating?
Even when a bond is going to be issued with insurance, it is common for issuers to get a rating "on their own." This rating is called an underlying rating.

So if the insurer were to be downgraded, the bond's rating would revert to the greater of the insurer's rating or the underlying rating.

Why not get an underlying rating?
S&P and Moody's charge issuers an exorbitant fee for a rating, so often smaller issuers or issues done for a one-off project don't get underlying ratings. Sometimes issuers choose to buy the insurance because insurance was cheaper than getting a rating.

A good example of a one-off project would be a deal I bought a while back for a new electrical substation at Georgia Tech University. GA Tech structured the deal such that it was off-balance sheet: they issued the bonds under their Foundation and then the Foundation leased the substation back to the university. A deal like that is unlikely to get an underlying rating for two reasons. First, its a one-time project, so paying for the rating would not have on-going benefits. Second, GA Tech is well known and the substation is obviously extremely important to the University. Investors logically assumed the rating would be about the same at the University's rating.

Up until recently, another category of issuers who did not get underlyings would be those that expected a Baa underlying. It was often assumed that having a Baa underlying would not improve the rate investors would pay, especially in the case of a general obligation issue. Now that is changing, as investors don't want to wind up with a non-rated bond in the event that the insurer is out of the picture.

What about trading levels in FGIC and XLCA bonds?
I think until either is downgraded, you won't see much trade. And it will depend greatly on the underlying rating.

What's the future for insurance?
I believe that insurance will continue to be a major part of the municipal market. I expect two major changes:

  • Somewhat fewer bonds will come insured, especially if they were Aa-rated on their own.
  • Very few issues will come with no underlying, even if its a Baa underlying. Many investors are restricted from owning non-rated bonds, so therefore even a weak underlying would allow the investor to continue to hold the bond.

But the basic advantage of owning insurance hasn't fundamentally changed.